Adjustable-rate mortgages (ARMs for short) and fixed-rate mortgages are the two of the most common types of mortgages.
The choice between adjustable vs. fixed-rate mortgages is one of the most common decisions for homebuyers. It’s frequently also the first question that needs answering when seeking a new home loan.
This article will look at the definition, differences, and benefits of each type of mortgage and why you might choose one over the other.
The fixed-rate mortgage
Fixed-rate mortgages charge a “set” or “fixed” interest rate that stays the same throughout the life of the loan.
A fixed interest rate means your total monthly payment stays the same from month to month.
This unchanging aspect makes it easier for homeowners to budget. Even though the principal amount (the original loan amount) and interest paid per month varies, your mortgage payment stays the same.
Benefits of fixed-rate mortgages
A significant benefit to a fixed-rate loan is protecting the borrower from any sudden (and possibly significant) rate increase.
In other words, their monthly mortgage payments should remain steady if market interest rates rise.
These types of mortgages tend to differ very little from lender to lender.
On the downside, qualifying for a fixed-rate loan with overall high-interest rates means affording your new home becomes more difficult—monthly payments will also be higher.
Conversely, fixed-rate mortgages become more attractive to homebuyers in low interest rate environments.
Like any mortgage loan, the amount of interest you’ll pay will depend on the loan term. Traditional lending institutions (like banks) offer different loan terms, the most common being 15, 20, and 30-year terms.
Long loan terms vs short loan terms
Naturally, 30-year mortgages are popular because they offer the lowest monthly payment amounts. However, 30-year mortgages are also generally the most expensive overall.
This extra expense is due to the extra ten-year amortization tacked onto the end of the loan term. As a result, you pay (basically) nothing but the accumulated interest during the last decade.
The shorter-loan-term mortgages will have higher monthly payments, but you’ll pay the principal off in a shorter period of time. Shorter-loan-term mortgages also tend to offer a lower interest rate—allowing the principal to be paid off quicker.
In the long run, shorter loan terms will cost you less—so long as you can afford the monthly payments.
Benefits of adjustable-rate mortgages
Interest rates for adjustable-rate mortgages will vary according to the prevailing market rate.
There is frequently an introductory period for ARMs with an introductory rate. This introductory rate will likely be set below the market rate of a comparable fixed-rate mortgage.
After the initial period with a lower initial interest rate has passed, the rate will rise with time. An ARM held for an extended period will usually surpass the going rate for a fixed-rate loan.
The introductory rate period can vary significantly—one month to ten years.
Afterward, the incremental rises in the mortgage interest rate are done at a pre-arranged schedule, usually annually.
Adjustable-rate loans are more complex than fixed-rate loans.
Therefore, to fully understand ARMs, it might be helpful to review some terms and concepts associated with these home loan types.
The rate at which the interest-rate adjustments occur.
Benchmarks tied to interest-rate adjustments. For example, a typical benchmark could be the London Interbank Offered Rate (or LIBOR).
Limits on the amount interest rates can increase in each adjustment period, also called “interest rate caps.” There can also be caps on your total monthly payments.
The highest adjustable interest rate permitted for the life of the loan.
A percentage added to the adjustment index. For example, if the adjustment index you are using is a one-year T-bill, and your margin is 2%, your interest rate will be the T-bill rate for that year (benchmark) plus 2% (margin).
The biggest advantage of ARMs
The most significant benefit of adjustable rate mortgages is that they are cheaper than fixed-rate mortgages. Or rather, they are for the first few years.
The initial low-interest period frequently enables borrowers to qualify for a larger mortgage loan.
If there is a falling-interest rate environment, the borrower can take advantage of a lower interest rate without needing to refinance.
Refinancing ARMs frequently happens when the market interest rates are low.
Borrowers who choose ARMs may save quite a bit of money during the introductory period, up to seven years. After that, however, the new rate will be set according to market rates.
If your mortgage loan is substantial and mortgage rates rise significantly, you could pay much more.
Adjustable vs fixed-rate mortgage—which is the best?
The main factors to consider when choosing the type of mortgage for your new home are—your personal finances, the strength and stability of the economy, and how much you think you can afford in the future.
This sort of consideration is especially crucial for first-time homebuyers.
Economies will wax and wane regardless of where you live, and interest rate changes will happen. What the rates are today will not be where they are next year (unlikely to be precisely the same).
Ask yourself these questions:
- What sort of mortgage payment can you afford right now?
- How long do you plan to live in this home?
- What do you anticipate will happen to interest rates?
Calculating your monthly payments
When considering ARMs, crunch your financial numbers and look at the worst-case scenario.
Remember that your monthly mortgage payments are based on the loan amount, your downpayment, the loan term, property taxes, premiums, and the ARM rate (which heavily depends on your credit score).
Can you afford the monthly mortgage payments if your ARM hits the interest rate cap? If yes, and you can apply the money you save during the fixed period toward extra principal payments, you will lower your overall costs.
If the adjustment indexes are at a higher rate and expected to fall, an ARM could be to your advantage. Conversely, if interest rates are expected to go up, or you want a predictable payment schedule, then fixed-rate mortgages might be the way to go.
Adjustable vs fixed-rate mortgages—the bottom line
When looking to purchase a new home, choosing the right loan type can help you avoid costly errors and save you money.
Remember—if you choose an ARM, you’re essentially gambling on the overall market’s direction. So that initial low rate you get may be the best decision you make or end up costing you quite a bit, particularly if your new home is at the limit of your affordability.
We have the experience, expertise, and personal touch to help you understand both the big picture and the small print.